We’ve had a nice little sell-off in the stock market over the last couple of days. I must say that it was a bit more intense than I had originally imagined, but I we’ll take it. There are some interesting setups all over the place on the long side. I think we can be patient though, pick our spots, and get involved in situations that present the least amount of risk for the most amount of reward.

All the bearishness out there still suggests that investors don’t have enough skin in the game. Investors Intelligence comes out with a report on the amount of bullish and bearish market newsletter writers. According to data compiled by Bloomberg, 37% of those writers were bearish during the week that ended October 25th. This puts the ratio between bulls and bears at 1.06, which is substantially less than the average of 1.60 since 1989 and the most recent peak of 3.65 in April.

From Bloomberg:

While the index posted the best return since 1991 in October, the ratio of bullish to bearish newsletter writers is “still quite low,” signaling investors who have missed the rally may be looking to purchase stocks, according to Christopher Verrone, head of technical analysis at New York-based Strategas.

Don’t bottom fish here – wait for the turn.High Chart Patterns did a nice job the other day explaining how to trade the reversal. We discussed last week how US Stocks and the Euro were positively correlated so there should be some interesting setups on the long side very soon for individual equities.

Mr. Edwards & Mr. Magee laid it out perfectly for us over 60 years ago:

“…here is the interesting and the important fact which, curiously enough, many casual chart observers appear never to grasp: these critical price levels constantly switch their roles from Support to Resistance and from Resistance to Support. A former Top, once it has been surpassed, becomes a bottom zone in a subsequent downtrend; and an old Bottom, once it has been penetrated, becomes a Top zone in a later advancing phase.”

This is technical analysis 101 guys. You can complicate things if you want, but all of those patterns with fancy and creative names all stem from the statement above. It’s technical analysis, but it’s a little bit of common sense too. Think about it: we know that there were S&P500 buyers here in March and buyers here in June. Do you know why the market got crushed after breaking below this level? Because the buyers ran out. Anyone willing to buy at this price had already bought, leaving only sellers. So if we know that there are only sellers left at this level, should we be surprised that the market is rolling over here? Of course not.

Now does this mean that we can never break above here and take off even higher? No. But I think that some selling here should be expected and it should take more than one attempt before penetration of the mid to high 1200s.

On the flip side, key resistance towards the top of that 3 month range was broken a couple of weeks ago. This broken resistance should become some support on any retests. I don’t think that we should be surprised to find buyers in that area if the market gets down there. With a rising 50 day moving average currently catching up with price, we could have some nice risk/rewards set up pretty soon. Be patient, let the market come to you:

The AAII sentiment surveys had the highest percentage of bears among financial advisors since March of 2009. As far as individual investors go, we saw the least amount of bulls since August of 2010. Both of those dates were important market lows. Sure enough, so was October 2011.

With just a couple of days left, the S&P 500 is on pace for the largest monthly gain since October of 1974. On Thursday the large-cap index soared 3% bringing the monthly total up to about a 13% gain for the month.

You can read the headlines and come up with a bunch of reasons why this month has been so spectacular for the bulls.

THE CHART

Forget all that, we’ll look at the technicals. Aside from the extreme sentiment conditions entering the month, the Treasury bond market has been absolutely decimated. They can’t sell them fast enough. Money flowed into the “safe haven” of U.S. government debt during the market sell-off this summer. But since the lows in stocks were put in earlier this month, Treasury bonds are being sold like Dutch tulips in 1637.

WATCH BONDS

Going forward we want to keep a close eye on what the bond market is doing. I cannot stress enough that if money keeps pouring out of this asset class, it has to go somewhere else. Money doesn’t just disappear, it is reallocated.

Stocks and commodities benefit greatly from this redistribution of funds. The iShares Barclays 20+ Year Treasury Bond Fund ($TLT) broke down hard yesterday as the stock market exploded. Its shorter term cousin —iShares Barclays 7-10 Year Treasury Bond Fund ($IEF) did the exact same thing, gapping down to levels not seen since early August.

I think that as this asset rotation continues, the stock market will benefit, but I am expecting a sharp retracement in both coming very soon. At some point next week I would imagine that we see some sort of Treasury rally that causes a pretty severe selloff in stocks. We are still in a choppy volatile environment so market participants have to be proactive. Pairs trades are very effective here. Money can be made on longs as well as shorts. Don’t be afraid to play both sides.

There is a ton of chatter out there about the amount of stocks currently trading above their 50 day moving average. We have come a long way fast – about 20% off the lows this month for the S&P500. Going into today, 94% of stocks in the index were trading above their 50 day Moving Average. These are some extreme levels:

I think this really plays into my thesis that taking some money off the table last week was probably a good idea. I mentioned how doing so was very difficult considering how bullish everything looked (see Here & Here).

October’s action was definitely a win for the bulls as the false move created a huge short squeeze. But now the battle begins with the 200 day moving average and 61.8% Fibonacci retracement around this 1270 level. I would not be surprised to see a test of 1230, near the top of the August/September range. This would allow the 50 day moving average to catch up and set up a nice risk/reward to re-enter the market.

Today’s Chart of the Day illustrates the Dow Jones Industrial Average adjusted for inflation going back to 1925. After one of the best month’s in the history of the stock market, I think it’s important for a little history lesson. According to ChartOfTheDay.com:

“When adjusted for inflation, the bear market that concluded in the early 1980s was almost as severe as the one that concluded in the early 1930s. Also, the inflation-adjusted Dow is up 145% since its 1929 peak and trades 74% above its 1966 peak – not that spectacular of a performance considering the time frames involved. It is also interesting to note that the Dow is up 86% from its March 9, 2009 low which is actually slightly more than what the inflation-adjusted Dow gained from its 1966 peak to today.”

As hard as it was for me to do, I spent the majority of the day getting smaller. When it feels like it’s the hardest thing to do, sometimes it’s the right thing to do. Maybe I’m early, and if that’s the case, it’s OK. I can accept that.

I just want to point out how important it is to watch the Bond market. @harmongreg and I were chatting yesterday about $TLT. I said,

Sure enough, we wake up this morning with a gap down in $TLT and here you go. This is what you get. On Tuesday I put up a post where I mentioned that a breakdown in $TLT would be “extremely positive for stocks”. Sure in theory it sounded great at the time, but seeing it play out really is a thing of beauty.

Taking a step back, it appears as though Treasuries are falling off a cliff. Just a guess here, but I think it’s inevitable that it gets down near the 200 day moving average around $100. If that’s the case, the melt-up in stocks should continue.

I am taking a more conservative approach here. Loaded up on cash and hoping to do some more of that tomorrow – Go into the weekend with some stock positions and plenty of cashola. Then set my self up to do a little shopping next week as individual names set up.

Shares of Bank of America are soaring today on news of Morgan Stanley’s downgrade of $BAC to “Equal weight” from “Overweight”, whatever that means. You have to laugh at this kind of stuff right?

I suppose, that in theory, this is negative news for $BAC stock. When a stock can’t go down on bad news, I take it as good news.

I realize there is a ton of news coming out of Europe that has an impact on all stocks, not just Bank of America. But on news of the downgrade, $BAC is up over 7% as of this writing. This means that today, it is outperforming $XLF $WFC $USB $BK among many others. Underperforming, however, relative to Morgan Stanley ($MS) today, which is up 15%.

All joking aside, I have to take this action in Financials as constructive. Big Gap up today in $XLF out of this range. A little back & filling here is welcome.

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